The Importance of Having an Emergency Fund
Saving for emergencies should be a top priority for all. Maintaining an emergency savings account may be the most important difference between those who manage to stay afloat and those who sink into debt. Keeping $500 to $1,000 of savings for emergencies can allow you to easily meet unexpected financial challenges such as:
• repairing the brakes on your car
Having an emergency fund not only provides you with the money to pay for these expenses, it also gives you the “peace of mind” knowing that you can afford these types of financial emergencies. Not having an emergency savings fund is an major reason that many individuals borrow too much money at high interest rates. For example, by saving for emergencies, Americans would probably not have to take out about $2 billion a year in payday loans at interest rates that average 300 to 500 percent.
Experts recommend that you create a separate emergency fund to cover your living expenses for three to six months or more. There are times when people become ill or are injured in accidents. Employers lay off workers. If something unexpected happens to you, having the money you need to pay the medical bills or see you through the weeks or even months of being out of work will help to keep you out of debt.
The best place for your emergency fund is in a liquid (easily accessible) account. A liquid account might be a regular savings account at a bank or credit union that provides some return on your deposit, and from which your funds can still be withdrawn at any time without penalty.
To earn a slightly higher interest rate, some people choose a CD for their emergency fund, or a series of CDs of approximately equal value, with one maturing every six months or every year. This approach is called laddering. You can roll over the CDs as they mature, to keep your ladder intact. The loss of interest you face for taking money out early may motivate you to keep your fund intact. But in a real emergency, the interest you may lose is a small price to pay for having the money you need. And if you have to spend any of the money, you should plan to replace it.
You might also consider buying U.S. Treasury bills with some of your emergency fund money. They, too, can be timed to mature on a regular schedule and, like CDs, they tend to pay more interest than a simple savings account. And while they aren't bank products, they are backed by the federal government. That means there is no risk of losing principal if you hold them to maturity. U.S. Treasury bills have very short terms—4 weeks, 13 weeks, or 26 weeks.
Other options for an emergency fund include money market mutual funds. A money market mutual fund is a mutual fund that must, by law, invest in low-risk securities, such as government securities and certificates of deposits. Compared with other types of mutual funds, money market funds are highly liquid, low-risk securities. Unlike money market deposit accounts, money market funds are not federally insured. While they are intended to pay dividends that are comparable to prevailing short-term interest rates, they can lose value.